Opportunities and Challenges Before the Aviation Industry

Aviation Industry: Key Opportunities and challenges in the near future

The aviation sector is being affected by several factors that are economic, technological, political and social in nature. However, industry sources have posted a positive outlook for this sector in the coming years. Despite a challenging industry environment in the recent years, aviation has continued to perform well being propelled fast by technological advancements and positive demand. In the coming years, it is expected to sustain its growth rate and demand is expected to rise. In 2017 two important forces supported the extraordinary performance of the aviation sector. Lower fuel prices and lower interest rates continued to fuel the growth of the industry and the airlines bonds saw heavy growth continuously for a third year. These trends have continued since 2015. 2015 had marked a starting point of a highly profitable new era for airlines industry when this industry sector saw its profits trebling.  There is a lot of good news coming from the aviation sector.

2017 saw several positive changes happening from capacity management to increase in load factor and a growth in RPK above the ten year trend of 5.5%. (RPK is a key airline metric used to calculate the number of kilometres travelled by paying passengers.)The leasing companies are also looking in better shape than ever. There used to be only 33 companies with assets higher than 1 billion dollars in 2015 whereas those with higher than 10 Billion dollars were only 5. The number of the former has risen past 50 and that of the later has also doubled almost.   Capital investors and banking institutions remained open towards the sector looking for attractive and stable returns. Signs of maturing of the sector are also visible from the incredible tightening of the pricing transactions which also shows a very high level of competition in the market. In the meanwhile questions have been raised regarding the continuous growth of the sector and whether it will be able to sustain its upward trajectory or if the  industry is going to see a downscale in the near future. Profit forecasts by the IATA confirm an upward trend in 2018. Challenges are still there but a robust 2017 showed that the industry was more than ready for these challenges.

While rising costs are expected to have a toll on the operating margins, IATA (International Air Transport Association) has made forecasts regarding a overall strong 2018. Apart from rise of net profit to 38.4 Billion dollars in 2018, the following are the highlights of the forecasts made by IATA.

– slight fall in operating margin to 8.1% in 2018 from 8.3% in 2017.

– Net margin to improve to 4.7% from 4.6% in 2017.

– Overall revenues to rise to 824 Billion dollars from 754 Billion dollars in 2017 (rise of 9.4%).

–  Rise in number of passengers from 4.1 Billion in 2017 to 4.3 Billion in 2018 (rise of 6%).

– Rise in cargo weight from 59.9 million tonnes in 2017 to 62.5 million tonnes in 2018.

– Compared to 2016-17 slower growth in both cargo and passenger in 2017-2018.

– Rise in average net profit per departing passenger from $8.45 in 2017 to $8.90  in 2018.

Rising costs will affect operating margin but yet the net profitability of airlines is going to improve. The reasons behind this rise are low interest rates, high demand and efficiency. The trends that began in 2015 are expected to continue in 2018. It is  going to be a fourth year of high profitability. According to the director general and CEO of IATA, this is a great period for the global airlines industry. The demand for air cargo and air travel are higher and employment as well as safety performance are solid. With new routes opening, airlines are achieving sustainable results. However, it is still a challenging business which is because of the rising, fuel, labor and infrastructure expenses.

There are several other long term challenges before the airlines industry too and the government is also affecting it in unprecedented ways. Governments would need to change several things so that the aviation industry can achieve better results. It needs to create  a smarter regulatory framework as well as  bringing taxation to reasonable levels. The aviation industry is delivering several large benefits to the society and that include a very high level of employment and a critical support for the global economic activity. Apart from employing more than 2.7 million people directly globally the aviation industry supports 3.5% of the entire economic activity. The aviation industry is the lifeline of modern life and it is ready to partner with the government to make air travel safer ad affordable for the people.

What are going to be the drivers of performance in the year 2018?

Rise in number of passengers:

In 2018 it is expected that the number of passengers is set to rise to 4.3 billion. RPK will be slightly lower than 2017 but still higher than the average of 5.5% at 6%. The average load factors will remain high at a record 81.4% driving 3% improvement in yields. Revenues from the passenger business are expected to rise to 581 billion dollars in 2018 against 532 billion dollars in 2017.  A expected strong growth of GDP at 3.1% in 2018 is going to support the growth in passenger demand.

Cargo:

Cargo volumes are expected to grow at 4.5% in 2018 falling from 9.3% in 2017. Cargo volumes had boosted in 2017 mainly due to the companies need to restock inventory faster to meet unexpectedly strong demand. Due to this the cargo volumes grew at a pace that was double that of the expansion of world trade. Generally restocking cycles are short lived but the growing commerce is expected to support the growth of cargo volume at a  rate higher than that of the expansion of world trade. Cargo revenues are expected to continue to shine in 2018 reaching 59.2 Billion dollars in 2018 as against 54.5 Billion dollars in 2017 ( growth of 8.6%).

Costs:

Rising costs are the largest challenge in the way of profitability of airlines businesses. Oil prices are expected to remain at an average of $60 per barrel for Brent Crude in 2018. This is a 10.7% rise from the rate of 2017. (However, oil prices for Brent Crude in May 2018 are around US$76/bbl, 60% higher than the same period previous year.) This is going to pinch those airlines harder that  have a low level of hedging compared to those with a higher hedging ratio. The fuel expenses are expected to become 20.8% of the entire costs in 2018 as compared to 18.8% in 2017.

Labor costs have grown fast and now constitute a larger expense than fuel in 2018 at 30.9% of the entire expenses.

Debt:

During the period that the industry saw rising profitability, it used its cashflows to pay dividends and to reduce debts. Debt to EBTDR ratio fell from 3.7 times in 2016 to 3.5 times in 2017. In 2018, it is expected to reduce further to 3.4 times. Lower debt also implies lower interest payments. Despite the decline in operating margin, net margin is expected to grow further in 2018 to 4.7% from 4.6% in 2017 which is because of the lower interest payments. It is going to let the net profits grow to 38.4 Billion dollars in 2018.

How are the various regions going to perform?

According to the IATA forecast, all the various regions are expected to perform better in 2018. Demand growth in all regions is expected to outperform capacity expansion. North American carriers will continue to lead in terms of performance accounting for about 50% of the entire industry’s profits. Here is the outlook for each region as highlighted by the IATA.

North America:

North America is leading the market with performance across this region set to touch the highest. Airlines in North America are set to generate the highest net profits of $16.4 Billion in 2018, rising from 15.6 Billion dollars in 2017. Market conditions are expected to remain sound with announced capacity growth (3.4%) expected to remain slightly lower than IATA’s traffic forecast of 3.5%. More than half of the profits that the industry produced during the last three years were generated by the North American carriers. However, due to the rising costs pressures further improvements have slowed down. Rising fuel prices have hit this region which is evident from the lower hedging ratios. Another issue is the pressure created by the rising labor costs. However, it is expected that the pressure is going to fall in 2018.

North American market has matured and despite there being some fare wars occasionally, profits have continued to rise for the players. Some pricing pressure is also there due to the entry of a few European careers. However, time will tell if this is going to have any major impact. US represents a stable market for the lessors and in terms of growth A relatively flat because major careers have their own fleets. In South America, there is mixed confidence but strong optimism that condition are growing better gradually. The Brazilian market is particularly inspiring strong confidence.

Asia pacific:

IATA forecasts that the airlines in Asia pacific are expected to see profits of $9 Billions in 2018 which will be a rise of 0.7 Billions from 2017. A major factor driving this change is the strong cyclical rise in cargo markets. Its careers account for 37% of the entire global cargo capacity. Moreover, anticipated growth in demand of 7% will outrun the announced capacity increase of 6.8%. Domestic markets have grown stronger in India, China and japan. There are regional variations in passenger market conditions. Moreover, the entry of low cost players in the ASEAN region is keeping profitability low by intensifying the level of competition. Long haul carriers are facing several challenges in their home markets causing the competitive pressure from them to reduce.    China is an important market for airlines and financiers too are quite optimistic about China because of the efficient infrastructure constructed in the recent years. On the other hand is India, all set to become the third largest civil aviation market by 2020 and to grow into the largest by 2030. The government is quite aggressive about the promotion of this sector and the freshest developments in the Indian market have dramatically lifted optimism.

Europe:

According to the  IATA forecast the European airlines are set to deliver a net profit of 11.5 Billion dollars rising from 9.8 Billion dollars in 2017. Announced capacity increases of 5.5% are behind the demand forecast of 6%. Strong recovery in the home markets including Russia is driving growth in Europe. Other factors supporting growth are recovery from terrorist events of 2016 and some consolidation following the failure of several regional airlines. The content achieved the highest average load factor in 2017 of 84.3% showing that these changes were producing strong results. While strong TransAtlantic demand continues to support strong performance, the new entrants are intensifying the already stiff competition. While Brexit, sovereign debt issues in Greece and Italy and high profile airline bankruptcies have dampened confidence, economies in Europe are still performing better than expected leading to higher customer demand and record high load factors. European carriers were enjoying a boom and Finnair had to thrice revise its profits forecasts upwards for the year. The Russian market has also showed signs of comeback.

Latin America:

According to IATA forecast, airlines in Latin America are set to generate 900 million dollars in 2018, rising from 700 million dollars in 2017. Passenger demand will grow at higher rate than announced passenger capacity growth (8% versus 7.5%). Moderate recovery in the Brazilian economy is adding momentum to the industry in Latin America. Apart from it, there are other factors driving growth of this sector like reasonable growth in Mexico and a weaker US dollar.  The Brazilian market is particularly inspiring strong confidence in Latin America.

Middle East:

IATA has forecast that the Middle East carriers are going to see net profits of $600 millions rising from $300 million dollars in 2017. Demand is expected to outrun announced capacity expansion (7% versus 4.9%). There are several challenges to the business models of the local carriers including low oil revenues, regional conflict and more issues like crowded air space. Apart from that travel restrictions to US and competition are also challenging growth. Signs of stress are visible in the middle east though it has been a major aviation hub. Despite it, there is a positive outlook for 2018. There are hot discussions about airline consolidation in the region as well. A link up by Emirates and Etihad or that between Emirates and FlyDubai could be possible.

    

Africa:

As per IATA forecasts the African careers are expected to continue to make small losses of $100 million a collective net loss worth the same in 2017. However, stronger economic growth   in the region is expected to propel demand growth of 8% in 2018 which slightly higher than the announced capacity expansion of 7.5%.  Regarded widely still as a volatile region, Africa does not have many solid airlines. However, there is a lot of optimism about market improvements, might be at a slow pace. Not all are pessimistic and may believe that the next wave of opportunities lie in Africa. There are several challenges before the African airlines including lack of government support. Nigeria has just emerged from recession and South Africa is experiencing weak growth. Traffic grows but passenger load factors are just above 70% which is at least 10% less than the industry average. Fixed costs are higher and the low utilisation is affecting profitability. While economic growth in 2018 could bring better results  but unless governments in Africa really pay attention and make efforts together, things will not change much and what many African governments believe is that airlines are the transportation of  the rich.

What is the size of the economic impact of the aviation industry?

– In 1996 the number of city pairs served by the airlines was only 10,000. This number has grown to 20000 in 2017 and is 1351 higher over the previous year.

– The inflation adjusted cost of air transportation to the consumers  is only half of what it used to be in 1996.

– The amount spent by international tourists on air travel is going to grow by around 15% in just over 2 years. In 2018, this sum is expected to reach 750 Billion dollars.

– In 2018, the value of goods that the airlines carry is expected to grow above 6.2 trillion dollars which is 7.4% of the global GDP.

– In 2018, direct employment by the airlines will have exceeded 2.7 million.

– According to the IATA forecast, each airline employee is expected to generate more than 109,000 dollars of gross value added that will be considerably higher than the economy wide average.

How is technology changing the airlines industry?

Technology has fundamentally changed many things in the airlines industry from the standards of convenience and passenger safety to pricing and efficiency. While the  entry of aircrafts equipped with new technology has changed the market situation, on the other hand the situation has grown even complicated with the introduction of several variants by major manufacturers. The standard economic useful life of an aircraft is 25 years and the advancement of new technologies has made many question if this should stay the same. There is also disagreement over the economic useful life of an aircraft and that whether it is 25 or 20 years.  Many others see technological advancements as growing the useful life of an aircraft. However, these technological advancements are not confined solely to equipment in the aviation industry. Digitalisation, big data and artificial intelligence are affecting the aviation industry just like the other industries.  Firms are using IT and better software tools to streamline processes and increase productivity. Not just aviation operations but aviation finance is also being affected by technological advancements in many ways.

Sources:

https://airlinegeeks.com/2016/01/17/airline-metrics-revenue-passenger-kilometers/

https://assets.kpmg.com/content/dam/kpmg/ie/pdf/2018/03/ie-navigating-the-cycle-aviation.pdf

https://www.iata.org/publications/economics/Reports/afm/Airlines-Financial-Monitor-May-18.pdf